Is U.S. Government Tactical Switch From Too Big To Fail To Too Big To Leave Constitutional?
By Rob Wright, Chief Editor, Life Science Leader
Follow Me On Twitter @RfwrightLSL
In the March 2016 issue of Life Science Leader magazine, my Editor’s Note, The U.S. Tax Man Cometh, The U.S. Corporations Leaveth, referenced the Pfizer-Allergan merger as pretty much a done deal. Little did I know then that the U.S. government would stoop to implementing government policies more familiar to those living in the former U.S.S.R., than a country founded on freedom and famous for supporting free enterprise. While not losing Pfizer (an American institution older than major league baseball) to Ireland can be considered a win for the good ‘ole US of A, I lament that the ends don’t justify the means. It seems the U.S. government has begun shifting its focus from “too big to fail,” to “too big to leave.” I for one wonder what will be the eventual outcome of such government activities in a free market society. Well for starters, Ireland-based Allergan will receive $150 million from Pfizer after the companies terminated their anticipated $150+ billion merger. A leading expert from Frost & Sullivan’s Transformational Health practice, Sangeetha Prabakaran, had this to say about the death of the recent deal.
“The merger was cancelled after the Obama administration focused on the deal. The merger would have moved the largest pharmaceutical company in the U.S. to Ireland to lower the company’s taxes.” While this most recent inversion attempt may have been reversed, it is doubtful that this will be the death of this practice.
Gaining An Understanding Of Inversion
According to Prabakaran, “Inversion is akin to a marriage of convenience. A U.S. company re-domiciles, typically through a merger with a smaller firm that is based outside of U.S. The combined company (Pfizer- Allergan) can lower its tax rates through internal borrowing and can shift profits to low-tax countries using a maneuver known as earnings stripping.” So what went wrong this time? According to numerous sources, the Pfizer-Allergan merger was targeted by the U.S. government. As such, the U.S. Treasury unleashed two major rules to thwart and end the biggest U.S. tax inversion ever attempted in the history of the pharmaceutical industry.
Rule 1: “The government would disregard U.S. assets acquired by such companies over the previous three years.”
In Allergan’s case, this nullifies the net effect of several cross-border deals including the purchase of Forest Laboratories in 2014, a takeover of Ireland-based Warner Chilcott PLC, and the stunner deal of Actavis’s $66 billion takeover of U.S.-based Allergan Inc. creating the current Allergan entity. With the new rule, Allergan’s market capitalization would hover around $106 billion, making it unattractive for Pfizer since lopsided mergers are a strict no-no under federal rules.
Under previous rules, which still apply, Allergan shareholders needed to own at least 40 percent of the combined company for the two companies to enjoy the full tax benefits of an inversion, and more than 20 percent to have any inversion benefit at all.
Rule 2: “The Treasury would seek to limit earnings stripping.”
As a result of this move, all non-U.S.-based companies, including the inverted ones, can lend money to their U.S. subsidiaries. This results in creating a deductible interest in the U.S., reducing the income subject to the 35 percent U.S. corporate tax rate and shifting income to a lower-taxed jurisdiction (in this case to Ireland where Allergan is based). If a U.S.-based company, say Pfizer, tried the same technique by borrowing from its offshore subsidiaries, the government would tax that income at the U.S. rate. This move exempts debt used for expansion of U.S. facilities. So what’s next? According to Prabakaran, Pfizer’s reliance on Allergan was more on the tax benefits and less Botox or Restasis sales, since Pfizer’s own (HER-2) breast-cancer drug Ibrance (palbociclib) has picked up strongly. Its pipeline of hypolipidemic drugs is strong, and Pfizer needs to stay focused on bringing the next Lipitor to market. Allergan, of-late, has been more focused on splitting off its generics business to Teva and reducing its debt. Allergan may continue to scout for generics partners while consolidating its position with Botox and building on a strong pipeline of age-related macular degeneration and depression.”
What Can Be Learned From Pfizer-Allergan?
While there are those that remain critical of the deal being a tax dodge, there are certainly some important lessons to be learned from the Pfizer-Allergan merger attempt. First, no matter how perfect things may look in building a deal, you can’t discount the possibility that an X-factor can disrupt even the best-laid plans. Second, in the near term it seems that U.S. inversions are as good as dead. Third, while there were some trying to sell the merger as being more than about taxes, if you apply the principle of Ockham’s razor, the simplest explanation is usually correct. Fourth, both companies probably will be just fine over the long run. But the fifth, most important, and in my opinion, scary lesson to be learned, is that the U.S. Department of Treasury did what even the U.S. Congress is prohibited from doing — passed ex post facto (i.e., retroactive) laws disguised as “rules.”
According to the clause 3 of Article I, Section 9 of the United States Constitution, “No Bill of Attainder or ex post facto Law shall be passed.” Further, states are also prohibited from passing ex post facto laws (see clause 1 of Article I, Section 10). If it is so important to prevent federal and state governments from adopting retroactive laws that make an act illegal, despite the fact that when the act was committed it was perfectly legal, shouldn’t we all be asking why then is U.S. Department of Treasury excluded from this practice? Imagine as a U.S. citizen that, based on the law, your federal tax bracket is 25 percent for 2015. Now imagine if one year later the federal government decides to change your income tax bracket to 35 percent and informs you that although you paid your taxes for the previous year based on whatever the laws were at the time, because they changed the laws ex post facto, you now owe an additional $20,000 in taxes for that previous year. This is basically what the U.S. Treasury did to effectively kill the Pfizer Allergan deal. And while I know everyone considers the deal to be dead, I for one hope Pfizer, Allergan, PhRMA, or someone from industry steps up to challenge the constitutionality of this “rule” in the U.S. Supreme Court. For if the U.S. government is capable of doing this to a company the size of Pfizer, what does this bode for Jane and John Q. Public?